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The Losers in the El Paso Corp. Opinion

By Steven Davidoff Solomon March 1, 2012 1:20 pmMarch 1, 2012 1:20 pm

Jin Lee/Bloomberg NewsThe headquarters of Goldman Sachs in Manhattan.

At first blush, a Delaware judge’s refusal to halt Kinder Morgan’s acquisition of the El Paso Corporation appears to be a big win for the two companies. Once you read the opinion, however, you realize that it is anything but a victory.

There are some big losers here, including Douglas L. Foshee, the chief executive of El Paso, and Kinder Morgan itself, which now faces potential liability in the hundreds of millions of dollars.

But the biggest loser may be El Paso’s investment bank, Goldman Sachs.

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This Delaware lawsuit arises out of Kinder Morgan’s $21.1 billion acquisition of El Paso. Shareholders of El Paso sued to halt the merger, claiming misconduct by El Paso’s board as well as Mr. Foshee and Goldman Sachs.

Chancellor Leo E. Strine Jr. of the Delaware Court of Chancery refused to halt the deal. But in his opinion, the judge took Mr. Foshee and Goldman Sachs to task, largely agreeing with the plaintiffs’ claims.

Chancellor Strine faulted Mr. Foshee for negotiating this transaction largely by himself, while hiding his own desire to buy El Paso’s pipeline business — a desire he expressed to Kinder Morgan’s chief executive, Richard Kinder, on two occasions but not to the El Paso board.

Mr. Foshee was supposed to be getting the maximum price for El Paso out of Kinder Morgan. Instead, Chancellor Strine observed that Mr. Foshee appeared more interested in currying Kinder Morgan’s favor in order to make this subsequent purchase.

This conflict was compounded by El Paso’s failure to “cabin” Goldman Sachs’s role despite the investment bank’s clear conflict. Goldman was inherently conflicted because it represented El Paso for part of the time in the sale negotiations with Kinder Morgan and advised El Paso on a possible spinoff of its pipeline business. But Goldman’s private equity arm also owns 19.1 percent of Kinder Morgan and has two appointees on Kinder Morgan’s board.

Although El Paso and Goldman took steps to ensure that this conflict was managed, Chancellor Strine found the effort faulty.

While Morgan Stanley was hired as a second adviser to El Paso because of this conflict, Chancellor Strine concluded that Goldman was able to continue to advise El Paso. Goldman also arranged the “remarkable feat” of limiting the scope of Morgan Stanley’s engagement so that it got paid only if El Paso was sold but not if El Paso decided to engage in an alternative transaction of a spinoff of the pipeline business. This alternative transaction remained the exclusive domain of Goldman Sachs.

Chancellor Strine describes this arrangement as having the effect of giving Morgan Stanley an incentive to focus solely on a sale of El Paso to the detriment of a possible spinoff of the pipeline business.

Goldman is described as also having an incentive for a sale. Its private equity arm owned $4 billion in Kinder Morgan stock, a disincentive from advising El Paso to conduct a spinoff. El Paso’s bankers were thus deterred from presenting the company with all of its possible options.

Having concluded that both Mr. Foshee and Goldman Sachs were inappropriately conflicted, Chancellor Strine then found “debatable negotiating and tactical choices” by El Paso. The company failed to challenge Kinder Morgan strongly when it threatened to go public with a hostile offer.

Instead of calling Kinder Morgan’s bluff, the chancellor concluded that Mr. Foshee was a “velvet-gloved” negotiator who inexplicably caved in to Kinder Morgan. Shortly after Kinder Morgan threatened to go hostile, Mr. Foshee and Mr. Kinder reached an agreement for Kinder Morgan to buy El Paso for $27.55 a share, only $2.05 more than Kinder Morgan had initially offered. At no time did El Paso or its bankers reach out to other parties to conduct a market test to see if this price was appropriate.

Chancellor Strine has a colorful description of what happened next:

Soon thereafter, on Sept. 23, 2011, Kinder said ‘Oops, we made a mistake. We relied on a bullish set of analyst projections in order to make our bid. Our bad. Although we were tough enough to threaten going hostile, we just can’t stand by our bid.” Instead of telling Kinder where to put his drilling equipment, Foshee backed down.

Kinder Morgan had reduced the price that it was willing to pay, and El Paso acquiesced. The ultimate deal was valued at $26.87 an El Paso share. Even here, Chancellor Strine finds fault with the parties criticizing the acquisition agreement for effectively precluding El Paso from making a “post-signing market check for bids for the separate divisions.”

Chancellor Strine brushes off Goldman’s defense that it was capable of ignoring its $4 billion investment in Kinder Morgan to advise El Paso independently. Instead, the judge highlights how Goldman was fighting for every dollar, securing a $20 million fee for advising El Paso on the sale while depriving Morgan of an assignment on a possible spinoff. Chancellor Strine speculates that if Goldman was so greedy for $20 million, it surely would be for $4 billion.

In what is one of the more hilarious asides in the pantheon of Strine opinions, the judge describes a call that the chief executive of Goldman Sachs, Lloyd C. Blankfein, made to Mr. Foshee to thank him for retaining Goldman Sachs. Chancellor Strine then states in a footnote that “certain chancery staff have experienced a troubling side effect to reading this evidence: Lionel Richie’s 1980’s treacle, ‘Hello,’ came to mind and is stuck in their heads.”

Faced with these lapses, Chancellor Strine still refused to halt the deal. The reason: An injunction, even for curative steps like requiring El Paso to make a fresh shop the company or its pipeline business, may have put the entire transaction at risk. Halting the acquisition altogether would merely deprive shareholders of the ability to receive the premium from the deal, even if the amount was lower than it otherwise should be.

The lawsuit remains outstanding and the plaintiff shareholders will now pursue a monetary remedy.

Chancellor Strine appears to be skeptical of the possibility of monetary damages. In the opinion, he noted that Mr. Foshee was possibly liable for hundreds of millions of dollars but could not personally pay that amount.

The judge also stated that the other El Paso directors were most likely not liable because they acted in good faith, while Kinder Morgan was merely doing what was expected of it.

And Chancellor Strine stated that the plaintiffs would have a hard time even pinning damages on Goldman Sachs since its conflicts were disclosed.

The judge’s cautionary language here may be an attempt to push the parties to settle. In truth, Mr. Foshee has insurance and Kinder Morgan agreed to indemnify him from these types of damages in the acquisition agreement. So, there is a real possibility of damages.

Although in fairness to Mr. Foshee and Goldman Sachs, they probably will continue to dispute that there was any impropriety, with Goldman likely to continue to argue that Morgan Stanley was not its puppet and freely signed off on the deal.

Yet the defendants will probably want to settle, given the possible liability and harshness of this opinion even with the caveats Chancellor Strine provided. Given that every dollar reduction in El Paso’s share price represents about $700 million, any settlement is likely to surpass the $89.5 million settlement in the litigation over the Del Monte buyout.

Goldman Sachs’s engagement letter with El Paso probably limits its liabilities to no more than $20 million, so this is a settlement that will mostly be paid by insurance and Kinder Morgan.

For those who are keeping track, the shareholder litigation arising from Richard Kinder’s own management buyout of Kinder Morgan with Goldman Sachs as a co-partner ultimately resulted in a $200 million shareholder settlement.

This decision once again shows that Chancellor Strine is a bold judge, one who is brilliant and willing to make waves. It is yet one more in a line of cases chastising chief executives for steering the negotiating process to their own benefit.

On the heels of the Southern Peru case, it also shows that criticism of Delaware courts for being soft on officers and directors may be too simplistic. Delaware courts appear increasingly willing to penalize conduct that they deem inappropriate and to call it into question.

Ultimately, Chancellor Strine’s opinion is likely to have its greatest effect in further regimenting how investment banks advise their clients. Going forward, expect investment banks to recuse themselves earlier in the process even if there is the barest appearance of conflict.

Moreover, the chancellor’s refusal to grant an injunction and instead allow a monetary damages award is a different approach than the one adopted by Vice Chancellor J. Travis Laster in the Del Monte litigation. There, the vice chancellor granted an injunction that effectively ordered Del Monte to shop itself. The judges have yet to adopt a consistent approach to this problem.

This brings us back to Goldman Sachs. Goldman was recently faulted by Chancellor Strine for its advice in the Southern Peru case, which resulted in a $1.26 billion judgment. The bank also switched sides in the J.Crew buyout, which resulted in a monetary settlement. On the heels of these cases, it is hard to see why Goldman Sachs was willing to risk its reputation again for a $20 million fee.

While it will continue to dispute these facts and its liability exposure is limited, Goldman is most likely the biggest loser because of its continuing self-inflicted the reputational wounds. This is another black eye.